The biggest (expected) news in the market this week is the start of “tapering” — the process of slowly reducing bond purchases by the US Federal Reserve, the organization in charge of maintaining financial stability.

But what does tapering even mean and how does this impact you?

Saw it coming from a mile away

It started back in March 2020. When the market cratered, the Federal Reserve started buying billions in bonds each to stabilize the economy.

• This kept interest rates low and made it easy for businesses and consumers to borrow money.
• The Fed committed to buying $120B bonds per month until the economy was closer to full employment and price stability.

That day was yesterday, when the Fed announced plans to start reducing purchases by $15B per month, until it stops altogether by July 2022. What could have been a scary event went better than expected.

• When the Fed tapered in 2013 — the market had a violent reaction from an unexpected announcement.
• But with the announcement this month — the market expected it, with consensus that tapering was necessary.

What does this mean for the markets?

Tapering typically leads to higher long-term interest rates (i.e. higher borrowing costs) — which cools down the economy.

Data: In the past four times when the Fed began policies that cooled down the economy (i.e. tapering, increasing short-term interest rates) the S&P 500 was:

• Down an average 2.9% — three months after the announcement.
• Up an average 2.75% — six months after the announcement.

Meaning: The market was more volatile in the short term but recouped losses in the long-run — i.e. investors were better off staying invested.

This time — “the question in the mind of the market is 100 percent what comes next” — according to former Fed economist, Roberto Perli (via NYT). And what comes next should worry investors even more…

Investors: Not out of the woods yet

Next on the Fed’s agenda — increasing short-term interest rates — which could hit the economy even harder.

• These rates directly impact consumer and business borrowing costs (i.e. mortgages, auto loans, equipment purchases, etc).
• Increasing rates would likely slow down the economy from slower business and consumer activity.

But increasing rates are also necessary to calm down inflation — which is running out of control. And the Fed doesn’t expect to increase interest rates until tapering is completed.

But that’s a problem for another day. For now, enjoy November-January — historically the stock market’s best months.

Must-reads: Why bank stocks benefit from rising interest rates.